RED FLAGS

PERCEPTION OF AUDITORS

Advance Financial Statement Analysis FAR741

Prepared for : Dr. Intan Waheedah Othman

Prepared by : Ahmad Tamim Ab Kadir (2019607864)

What is a Red
Flag?
● Red Flag is a set of circumstances that are unusual in nature or vary from the
normal activity
● It is a signal that something is out of the ordinary and may need to be investigated
further
● Red flags do not indicate guilt or innocence but merely provide possible warning
signs of fraud
● Do not ignore a red flag, sometimes an error is just an error
5 Selected Articles
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A4 A3
FLOW OF
PRESENTATION
Introduction 01 Literature
02 Review
Methodology 03
04 Findings
Conclusions 05
 01
INTRODUCTION
 Introduction
A1 (US) A2 (Malaysia)

• This study examines the perceived • The purpose of this study is to examine
effectiveness of red flags in the detection effectiveness of US Statement of
of fraudulent financial statements Auditing Standard (SAS) No. 99 red
between external and internal auditors. flags in detecting fraud as perceived by
• This study attempts to identify any both the Malaysian internal auditors and
differences between external and external auditors.
internal auditors in their perceived fraud- • SAS No. 99 and International Standards
detecting effectiveness of SAS No. 99 on Auditing require external auditors to
red flags. use red flags in detecting fraudulent
• This study explores why some auditors financial reporting activities, while
would perceive red flags to be ineffective conducting financial statement audits.
in detecting fraudulent activity, while
others consider the same red flag as
very effective in fraud detection.
 Introduction (cont.)
A3 (Lebanon) A4 (Indian)

• Most of the studies on auditors’ • The research paper aims to

perceptions towards the understand awareness level about
effectiveness of the international red flag among auditors.
standard on auditing 240 Red Flags • This study aims to identify auditor’s
were conducted in developed perception about effectiveness of
economies. red flag in fraud prevention and
• This study determines whether red detection.
flag can be helpful for Lebanon
certified public accountant (LCPA)
working in auditing firms by
detecting fraudulent financial
reporting (FFR).
Introduction (cont.)
A5 (Hong Kong)

• This study examined auditors’

perceptions of the relative level of risk
of fraud and material irregularities
associated with the presence of six red
flag factors and also evaluated the
quality of auditors’ judgements.
• This study examines Hong Kong
auditors’ perceptions of the extent to
which they regard the existence of
selected red flags in a specific
hypothetical situation as indicators of
the existence of fraud and error.
02
LITERATURE
REVIEW
 Literature Review
A1 (US) A2 (Malaysia)

• Albrecht and Romney (1986) showed that partners perceived • Research suggests that the use of red flags is effective for
that only one-third of the red flags were considered significant identifying fraudulent financial reporting (Hegazy and Kassem,
predictors of fraud. 2010; Moyes et al., 2006).
•Heiman-Hoffman and Morgan (1996) emphasized the fact that •Studies show that not all red flags are equally effective for
red flags did carry different weights as perceived by the detecting fraud and internal and external auditors perceive the
sample of auditors. The results showed the auditors tended to fraud detection effectiveness of red flags differently (Heiman-
rate “management attitudes” (dishonesty) as the most Hoffman et al., 1996; Moyes, 2006).
important category of red flags compared to other •Moyes et al. (2006) found internal auditors’ perceive ‘attitude’
organizational factors. or rationalisation red flags as most effective for fraud
• Pincus (1989) found that only half of the auditors indicated detection.
they used red flag questionnaires to assist in their fraud •Albrecht and Romney (1986) found that audit partners
assessment, since they considered red flags an important tool perceive red flags concerned with personal characteristics of
in the audit process. However, for the other respondents, one management as effective for fraud detection but perceive
may conclude that non-use of red flag questionnaires company-specific red flags to be ineffective for fraud
indicates these auditors did not perceive red flags to be good detection.
indicators of fraudulent activity. • Apostolou et al. (2001) found that auditors perceive red flags
•Hackenbrack (1993) found that auditors assigned primarily to related to personal characteristics of management and
large-client engagements placed more emphasis on factors influence over the control environment as most effective for
(red flags) relating to the opportunities of perpetuators to fraud detection.
commit fraud than auditors examining small clients.
 Literature Review (cont.)
A3 (Lebanon) A4 (Indian)

• External auditors should keep track of several • Gullkvist & Jokipii (2013) found that any single red
indicators (red flags) and apply different ways in flag cannot be emphasized in all the situations
discovering manipulations (Yücel, 2013). • The red flags identification increases auditor’s
• Yücel (2013) suggested that identifying the sensitivity toward fraud presence (Krambia-Kaparis,
significant alert signals (red flags) must aid the 2002).
external auditors in performing better assessment • Auditors who separately assess fraud risk pay more
of fraud risk. attention to red flags and increase sensitivity toward
• Moyes et al. (2013) stated that external auditors fraud (Zimbelman, 1997).
should determine the actions that are considered as • Strained auditors management relationship acts as
red flags, which can point out to the a significant indicators (red flags) of potential fraud
pressures/incentives, attitudes/rationalizations, and (Moyes et al., 2006).
opportunities to commit fraud.
• Kassem and Higson (2012) asserted that the ISA
(240) encourages the external auditors to take in
consideration both the exterior and interior
elements that influence the firm and may generate
pressure, opportunity, and create an environment
that enables managers or employees to rationalize
perpetrating fraud.
Literature Review (cont.)
A5 (Hong Kong)

• Red flags may be described as “potential

symptoms existing within the company’s business
environment that would indicate a higher risk of an
intentional misstatement of the financial
statements” (Price Waterhouse, 1985, p. 31)
• The existence of these red flag factors is expected
to affect the auditors’ assessment of inherent risks,
which in turn, will affect the planned detection risk
(Colbert, 1987, 1988).
• In early 1970s, Touche Ross designed a set of
warning signals (red flags) for fraud based on
economic factors and business structure factors
(Pincus,1989).
• The study found that the “signals” or red flags are
used extensively by auditors (Konrath, 1989)
METHODOLO
GY

03
 Methodology
A1 (US) A2 (Malaysia)

•The researchers purchased a list of its members from the • Total of 52 Malaysian internal auditors and 40
American Institute of Certified Public Accountants (AICPA),
which 2,000 questionnaires were sent. Malaysian external auditors completed and
• For the internal auditors, the researchers posted the returned the questionnaire.
questionnaire to the Global Auditing Information Network • Use Mean and T-tests to determine whether
(GAIN), an affiliation of the Institute of Internal Auditors (IIA), significant differences existed between external
which approximately 1,800 internal auditors who are members
of GAIN and scattered across the United States. and internal auditors with respect to their
•Survey data were collected over a six-month period perceived level of effectiveness of red flags as
•Both response rates are relatively low for two reasons: (1) the predictors of fraudulent financial reporting
red flag questionnaire was very long in length, and (2) the red activity.
flags are a difficult subject for both external and internal
auditors to understand and to be able to evaluate their
effectiveness.
•the auditors would evaluate the level of fraud-detecting
effectiveness of each red flag by selecting one of the six
following responses (a six-point Likert scale)
•Use Mean, Variance, Regression, T-tests and the Wilcoxon
Rank Sum to determine whether significant differences
existed between external and internal auditors with respect to
their perceived level of effectiveness of red flags as predictors
of fraudulent financial reporting activity.
 Methodology (cont.)
A3 (Lebanon) A4 (Indian)

• The sample of the field study is 10% of the population • Research sample includes practicing chartered
130 questionnaires were distributed among Lebanese accountants working in different audit firms and
Association of Certified Public Accountants (LACPA) indulged in any kind of audit work.
working in these firms. • 100 auditors were approached. Out of which, 90
• The researchers used a questionnaire as a method for auditors responded to the questionnaire. Ten auditors,
collecting data. who did not reply, claimed that they have never used or
• The research instrument is the five-point Likert scale listened about the concept of red flag.
which used in the design of the questionnaire. • Questionnaire was filled through direct personal
• Use Cronbach’s alpha values, Correlation Analysis, contacts to auditors. The confidentiality to respondents
Regression Analysis and One-Sample Wilcoxon Signed was assured which motivates them to frankly answer
Rank Test the questionnaire and increases the reliability of the
• The one-sample Wilcoxon signed rank test is a non- questionnaire.
parametric alternative to one-sample t-test when the • Use Cronbach’s alpha values, Mean, T-tests and Tukey
data cannot be assumed to be normally distributed. It's post hoc analysis
used to determine whether the median of the sample is • Tukey's range test, also known as the Tukey's test,
equal to a known standard value (i.e. theoretical value). Tukey method, Tukey's honest significance test, or
Tukey's HSD test, is a single-step multiple comparison
procedure and statistical test. It can be used to find
means that are significantly different from each other.
Methodology (cont.)
A5 (Hong Kong)

• Partners and managers in three prominent CPA firms

(consist of 3 were returned by audit partners, 11 by
audit managers and 12 by audit seniors in Hong Kong
agreed to assist in the preliminary survey.
• The questionnaire used in the preliminary survey,
indicate the likelihood of material misstatements by
using a 7 point Likert-type scale (1: not important; 7:
very important)
• The second stage of the study, factors were selected
for the lens model study.
• The lens model originated in Egon Brunswik’s concept
of probabilistic functionalism, which is primarily a theory
of perception.
• Subjects for the lens model study were volunteer
auditors from a cross-section of Big 6 audit firms in
Hong Kong who did not participate in the preliminary
questionnaire survey.
FINDINGS

04
 Findings
A1 (US) A2 (Malaysia)
•42% of the external auditors have detected fraud using red • The Malaysian external auditors (means: 3.40; 1st rank is
flags and may not be convinced of their fraud detecting inadequate segregation of duties or independent checks )
effectiveness. perceive a wider range of fraud detecting effectiveness of the
•More experienced internal auditors tend to rate the 29 opportunity red flags than the Malaysian internal auditors
effectiveness of red flags higher than less experienced (means: 3.00 maximum; 1st rank is large amounts of cash on
internal auditors. hand or processed ).
• There was no significance in perceived fraud-detecting •The Malaysian external auditors (means: 3.23 maximum; 1st
effectiveness were found among the various levels of training rank is Management and/or board of directors holding
for either group of auditors. significant financial interest in the entity) perceive a wider
•The external auditors’ perceived effectiveness of red flags is range of different levels of the fraud detecting effectiveness of
significant, while internal auditors’ perceived fraud-detecting the15 pressure red flags than the Malaysian internal auditors
effectiveness of red flags is not significant. (means: 2.71 maximum; 1st rank is new
• No significances were found for external auditors with regard accounting/statutory/regulatory requirements).
to the size of the firm that the auditor works with. While • The Malaysian external auditors (means: 2.98 maximum; 1st
internal auditors, It was theorized that the larger firms would rank is unreasonable demands on the auditor, such as
tend to place more emphasis on red flags due to their client unreasonable time constraints regarding the completion of the
base, thus increasing the importance and perceived audit) perceive a wider range of different levels of the fraud
effectiveness. detecting effectiveness of the15 rationalisation red flags than
•Both external and internal auditor groups, females more than the Malaysian internal auditors (means: 2.73 maximum; 1st
males might tend to regard red flags as much more effective rank is excessive interest by management in maintaining or
in order to detect fraud and avoid serious ramifications if the increasing the entity’s stock price or earnings trend).
fraudulent activity was occurring but was not detected.
 Findings (cont.)
A3 (Lebanon) A4 (Indian)

• A positive significant association between • Auditors were found to be aware about red
pressures red flag and fraudulent financial flag but not very highly aware due to fact
reporting occurrence in Lebanon. that auditors do not think about presence of
• A positive significant association between any of their responsibility toward fraud
level of opportunities and fraudulent detection.
financial reporting occurrence in Lebanon. • Auditors in the present study were of the
• A negative significant association between view that red flag helps in fraud detection
attitudes/rationalizations and fraudulent but they were disagreeing about presence
financial reporting occurrence in Lebanon. of red flag means actual presence of fraud.
• ISA 240 Red Flag for fraudulent financial • Auditors in regional and national audit firms
reporting can aid external auditors in were highly aware of red flags compared to
detecting fraud in Lebanon. local firms.
• Auditors with less experience i.e. newly
qualified chartered accountants consider
red flag as most effective in comparison
with auditors with high experience.
Findings (cont.)
A5 (Hong Kong)

• Misstatements detected in prior audits were

perceived by auditors to be the most
important factor in identifying the risk of
material errors and irregularities.
• The second most important red flag is an
indication of going-concern problem, which
may be caused by other factors including
management fraud.
• The other four red flags, contentious
accounting issues, difficult-to audit
transactions, management operating style
and management attitude on financial
reporting had relatively low therefore, not
perceived by respondents as very important
as signals of fraud and irregularity.
CONCLUSION
S

05
 Conclusions
A1 (US) A2 (Malaysia)
• External auditors seem to perceive red flags as more • Malaysian auditors perceived each red flags as having
effective generally in detecting fraud than internal a different level of fraud detecting effectiveness.
auditors. • The Malaysian external auditors generally perceive a
• For external auditors, significant indicators of red flag slightly larger range of different levels of fraud detecting
effectiveness were found with variables that measured effectiveness of opportunity, pressure and
actual “hands-on” use of red flags such as exposure to rationalisation red flags than the Malaysian internal
red flags, how often one uses red flags, the auditors.
organization’s effectiveness with red flags, and the use • The greatest number of significant differences (12 out
of red flags to detect fraud. of 59 red flags) in the perception of red flags
• For internal auditors, more experienced internal effectiveness between Malaysian external and internal
auditors perceived the 42 red flags as being more auditors exists in the category of opportunity red flags.
effective in detecting fraud than less experienced
internal auditors.
• For both external and internal auditors, female auditors
rated the red flags consistently more effective in the
detection of fraudulent activity than male auditors.
• Even though the questionnaire was pre-tested and
validated, it is still possible that some misinterpretation
of the questions might have occurred.
• the response rates were low and it is possible the
sample might not be representative of the population of
auditors in the United States.
 Conclusions (cont.)
A3 (Lebanon) A4 (Indian)

• The finding provides a strong evidence that ISA 240 • Present study would be of immense importance to
Red Flags for fraudulent financial reporting can aid regulator, accounting professionals, managers and
external auditors in detecting fraud in Lebanon. researchers, which emphasizes the importance of red
• The list of specific red flags for fraudulent financial flag in fraud detection and prevention.
reporting that were used in this research can be used in • Perception toward effectiveness of red flag has been
conjunction with SAS 99 Red Flags to enhance external considered which is based on their work experience so
auditors’ ability in detecting fraudulent financial their previous knowledge and personal biasness can
reporting. affect their response.
• The researchers were not able to get more than 130 • In Indian context, fraud risk management is a reactive
LCPA working in the audit firms in Lebanon out of 1300 approach (reactive approach is based on responding
LACPA to fill in the questionnaire and thus the results to events after they have happened).
cannot be generalized to all LACPA working in • Around 41% companies did not having formal fraud risk
Lebanon. management framework (KPMG, 2010).
• The current research recommends LACPA working in • The findings of this study emphasized that accounting
the audit firms in Lebanon to focus their efforts more on regulatory bodies Institute of Chartered Accountants of
high quality red flags, which will in turn facilitate fraud India (ICAI) and Institute of Cost & Works Accountants
detection in the financial statements. of India (ICWAI), to take effective steps to spread
awareness about red flag among accounting
practitioners and train them in order to recognize red
flag and to take effective action on its presence.
Conclusions (cont.)
A5 (Hong Kong)

• The subjects were drawn from a cross-section

of the Big 6 firms in Hong Kong and their
perceptions may not reflect the views of the
population of auditors in Hong Kong and
elsewhere.
• The artificiality and simplicity of the
experimental situation could have affected the
results.
• This study which provides some insights into
auditors’ perceptions of, and decisions about,
red flag factors was conducted in two stages.
• This study also provides some preliminary
evidence regarding the role of heuristics and
probabilistic functionalism in the auditors’
decision making process.
THANK YOU
 Sources
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99 red flags between external and internal auditors. Journal of Business & Economics Research
(JBER), 5(6).

2. Moyes, G. D., Young, R., & Mohamed Din, H. F. (2013). Malaysian internal and external auditor
perceptions of the effectiveness of red flags for detecting fraud. International Journal of Auditing
Technology, 1(1), 91-106.

3. Hijazi, W., & Mahboub, R. (2019). Auditors perceptions towards the effectiveness of the international
standard on auditing 240 Red Flags: evidence from Lebanon.

4. Mangala, D., & Kumari, P. (2016). Auditors’ Perception of Red Flag: Indian Evidence. Mangala, D. &
Kumari, P.(2016). Auditors’ Perception of Red Flags: Indian Evidence. In Usha Arora, Deepa
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97-111.

5. Majid, A., Gul, F. A., & Tsui, J. S. (2001). An analysis of Hong Kong auditors' perceptions of the
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